Virtual Currencies: a House of Cards or a Mass Market Trend? The Answer to that Question Remains Pending

A few years ago, virtual currencies (VCs), and Bitcoin specifically, were practically unknown. Now they feature regularly in the media and make news headlines. But how real are they? And how do we regulate the use of VCs? VCs are certainly ‘real’, and they are here to stay for the foreseeable future. But what is also certain is that they are fraught with uncertainty and anxiety.

One reason for the rising public interest may be the fascination with the mysterious origin of Bitcoin. Its presumed creator is an individual or a group of people. Recently a Newsweek journalist claimed to have revealed the true identity of the Bitcoin founder, supposedly a 64-year-old Japanese-American named Satoshi Nakamoto. However, Mr. Nakamoto has denied his involvement. The mystery remains.

How does the technology behind Bitcoin work?

Another factor in Bitcoin’s attraction is the underlying technology – Bitcoin technology is new, dynamic and evolving. In 2009, the first units of Bitcoin appeared. Bitcoins exist as computer code based on cryptography and are stored on electronic wallets. Bitcoin does not require a central clearing house or financial institution clearing transactions. Users must have an internet connection and Bitcoin software to make payments to another public account/address. The user can send payments within a decentralised, peer-to-peer network, can purchase and sell Bitcoins through online exchanges and trade Bitcoins for traditional currencies.

A total of about 12 million Bitcoins are currently in circulation, with another 3,600 new Bitcoins entering the market each day. The system is designed to produce no more than 21 million Bitcoins.

Does Bitcoin make you rich?

A further appeal of Bitcoin is linked to the perception that it enables the investor to create enormous wealth. That might have been true in Bitcoin’s earlier days: when the currency first emerged in 2009, it was worth a fraction of a US$ cent. In 2013, Bitcoin started the year at just 13 US$. And then it reached a peak value of 1,200 US$ in early December 2013. Thus enormous financial gains were possible at the right time. But from that peak the price of Bitcoin plummeted: in mid-January 2015, it stood at less than 200 US$. Mismanagement, cyber-attacks and theft of a substantial amount of Bitcoins forced a market-leading exchange (Mt. Gox) to file for bankruptcy and close its doors. In addition, several jurisdictions started to subject Bitcoin transactions to tax.

While Bitcoin has generated interest as an investment, many perceive its value primarily as an alternative payment method: Bitcoin transactions are faster and cheaper than traditional payment transactions routed via banks. Bitcoin is thus touted as helping financial inclusion of the unbanked: populations that do not have bank accounts but can access the internet could theoretically make or receive Bitcoin payments. However, these benefits are more relevant in emerging markets and less relevant in the European Union (
), where existing and pending
Regulations and Directives are already explicitly aiming at increasing transaction speed and reducing cost. The advent of the Single Euro Payments Area (
) has played an important part in this regard.

The changing sociology of the Bitcoin user

Analysing who it is that uses Bitcoins is quite interesting. The early adopters were typically technology (and math?) enthusiasts ready to try something new. They were soon joined by people who either lacked confidence in the traditional banking system or wanted to find a way to escape what they saw as the capitalist oppression by banks and dominance of governments – and teach them a lesson. And criminals are said to have discovered that Bitcoin could be a conduit for money laundering, drug trafficking and computer hacking. Now we see that in contrast to the earlier Bitcoin years, the sociology of the Bitcoin user – and potential user – is changing. We find a broad spectrum of people of all ages using Bitcoin.

Many suppliers are ready to meet the demand

On the supply side, the infrastructure needed to support VCs is building rapidly. New suppliers appear on the market on a nearly daily basis: they range from providing trading and brokerage platforms, processing services, software products and mining services to information and marketing services, VC apps and digital wallets. In 2014, a Nordic venture capital company created a ‘Bitcoin Database’ tracking the number of new start-ups connected with VCs. If one believes their data, the number of new start-ups is growing swiftly. A whole new industry is being created in response to VCs.

Each day additional merchants, large retailers, e-commerce companies, airlines, hotels and others announce that they are willing to accept Bitcoin. CoinDesk, an online publication that tracks digital currencies, estimates that by the end of 2014, 100,000 companies accepted Bitcoins. Finally, exchanges keep adding to the range of ‘real’ currencies that one can use to buy or sell Bitcoins including, but not limited to, US Dollars, Sterling, Euro, Polish Zloty, Renminbi, and Mexican Peso.

The demand for Bitcoins remains limited

The number of Bitcoin wallets (an indication of how many users have bought Bitcoin) is increasing. Coindesk estimates that by the end of 2014 there were eight million bitcoin wallets globally. However, this number represents less than 2 percent of the
population, for example. In its opinion on virtual currencies, published in July 2014, the European Banking Authority (
)1 pointed out that “using a generous interpretation, the number of global virtual currency transactions has never exceeded 100,000 per day across the globe, compared to approximately 295 million conventional payment and terminal transactions per day in Europe alone (i.e. credit transfers, direct debits, e-money transfers, cheques, etc.)”.

If people aren’t using Bitcoin to transact, are they using it to invest? Between 55 and 73 percent of Bitcoins are not in circulation, but are simply ‘hoarded’, i.e. they are held in accounts rather than being traded or spent. One suspects that this has to do with Bitcoin’s price volatility: if you have bought Bitcoins hoping that the investment might make you rich, but the Bitcoin price falls, you are probably trying to sit out the volatility cycle and will only sell or use Bitcoins once the price increases again. Another finding is that a majority of Bitcoin users have very few Bitcoins, and only very few users have large amounts of Bitcoins.

So the demand is not (yet) keeping up with the supply side. Will that change in the future, and how soon?

Much will depend on regulation. VCs are not legal tender in any country of the globe right now, and in many countries restrictions around dealing and trading with Bitcoins exist. In others, regulators are grappling with arriving at an exact definition of VCs. After all, you can only regulate something if you are clear about what it is.

How can VCs be regulated?

National regulators everywhere have started to review VCs. Some have banned VCs, others restrict certain activities, and a third group are still monitoring and reviewing their position. Several central banks have issued warnings to their country´s citizens about the risks of investing in VCs. And pan-European authorities such as the
and the European Central Bank have launched studies and reviews.

In its opinion on VCs, the
states, among other things: “Following three months of analysis, the
issued a public warning on 13 December 2013, making consumers aware that VCs are not regulated and that the risks are unmitigated as a result. The question that remained unaddressed at the time was whether VCs should or can be regulated. This
opinion sets out the result of this assessment and is addressed to
legislators as well as national supervisory authorities in the 28 [
] Member States. (…) More than 70 risks were identified across several categories, including risks to users; risks to non-user market participants; risks to financial integrity, such as money laundering and other financial crime; risks to existing payment systems in conventional FCs [Fiat currency], and risks to regulatory authorities. A regulatory approach that addresses these drivers comprehensively would require a substantial body of regulation, some components of which are untested. It would need to comprise, amongst other elements, governance requirements for several market participants, the segregation of client accounts, capital requirements and, crucially, the creation of ‘scheme governing authorities’ that are accountable for the integrity of a VC scheme and its key components, including its protocol and transaction ledger.”

The
opinion also recommends several “immediate responses” to be taken by national supervisory authorities and the
legislator, respectively. As one immediate response, the
recommends that “national supervisory authorities discourage credit institutions, payment institutions and e-money institutions from buying, holding or selling VCs.”

It remains to be seen what specific
regulatory action, if any, will result from the
opinion.

As Bitcoin, the most popular among a whole host of VCs, is gaining momentum, many governmental authorities are now focusing on how these VCs can be used and misused. The questions raised are not simply ones such as “should Bitcoin be regulated or not”? Rather, the fundamental questions start with an exact definition of a VC. Are VCs legal currencies? Are they an ‘asset’, a ‘property’, a ‘financial unit’? If they are an asset, is it taxable? If so, does capital gains tax apply?

Three participants

Beyond trying to define what VCs actually are, regulators have been looking at the participants in the VC market. Typically there are three participants:

An ‘administrator’ (who issues VC and has the authority to withdraw VC from circulation).

An ‘exchanger’ (who is involved in the exchange of a VC for traditional, hard currency or for other virtual currency).

The ‘user’ (who obtains convertible VC and uses it to purchase real or virtual goods or services).

Each type of participant may fall under one or another already existing law or regulation. For example, in some jurisdictions, VC administrators and exchangers are considered ‘money transmitters’ and are thus subject to regulation, while users are not. As a money transmitter, a VC administrator or an exchanger is required to register as a money services business and is subject to regulations as would any ordinary money transmitting service dealing in traditional currency. Those who use VCs exclusively for common personal transactions like receiving payments for services or buying goods online, would qualify as users and are thus not regulated.

In some countries (e.g. the US), VC administrators and exchangers are also subject to numerous other regulations, including complying with the requirements that they implement an anti-money laundering / know your customer (AML/KYC) program, as well as record keeping requirements and reporting obligations. Failure to register as a money transmitting business is punishable by civil penalty, and operating as a money transmitting business without registering is a criminal offense.

Beyond the definition of whether someone is an administrator, exchanger or user additional legal questions arise: if a user ‘mines’ a convertible VC solely for his or her own purposes, is the user then a money transmitter or not? Is a company that purchases and sells convertible VCs as an investment exclusively for its own benefit, and that produces and distributes software to facilitate such purchases, a money transmitter or not?

Criminals are not waiting for regulatory definitions

Clearly, VC regulation is a hugely complex area and novel legal questions arise continuously. In the meantime, VC usage has started to take off, even though many jurisdictions have yet to fully define what a VC is and how it should be regulated. Some of these early VC adopters are possibly criminals. According to law enforcement authorities, VCs’ high degree of anonymity have induced criminals to use VCs and particularly Bitcoin, to commit crimes, launder money, and evade law enforcement, and a number of cases are now coming before the courts.

Regulation around the globe

Unfortunately, regulation is typically initiated at a national rather than regional or even global level. Therefore, multiple countries around the world have reviewed VCs and in some cases passed legislation.

In essence, the regulatory response to date can be categorised as follows:

Some countries have prohibited banks and payment institutions from dealing in Bitcoin altogether. Examples are Japan, China, Thailand and India.

Some countries have been setting strict rules where using Bitcoin for purchases is permitted, but trading, creating a market or operating an exchange etc. requires a license from the national regulator. Examples are Germany and the US.

Some countries have not passed regulation yet, but are monitoring and investigating the Bitcoin market. Examples are Canada, the UK, and France.

With regard to several countries definite information on their planned regulatory approach is not yet available.

At present, VCs represent a miniscule amount of transactions globally. However, many retailers and small businesses are sufficiently attracted by the perceived advantages of Bitcoin (lower transaction fees, speed, anonymity, no charge-back) so that they are considering doing business in Bitcoin. Depending on the jurisdiction in which the retailer or small business operates, entering the VC market will have significant implications. In addition to registration and AML/KYC compliance, businesses that operate as VC brokers must consider consumer protection obligations.

The regulatory response will ultimately depend on whether VCs will become a viable alternative payment method as well as their impact on financial stability and monetary policy

Currently VCs are neither widely used nor well understood by most. The current volume of VC transactions around the world is minimal, compared to the volumes that banks and payment systems handle. But Bitcoin´s six-year history has clearly demonstrated its extremely high volatility, its risk of manipulation and that it is vulnerable to hacking or electronic system failures. Most recently, on 6 January 2015, it was reported that “Bitstamp, Europe’s leading Bitcoin exchange, had suspended operations following an apparent breach which led to a loss of millions of dollars of the virtual currency” (Electronic Payments International). Central banks in several jurisdictions are not concerned about the impact of VCs on the financial stability or monetary policy of the market they regulate – yet. However, should VCs become more widespread as alternative payment means, central banks will be highly interested in determining the likely consequences on their economies and respective national currencies, and of course on domestic consumers, i.e. the constituency whom they ultimately must protect.

Edith Rigler has been active in the international payments arena for many years. She held managerial positions with several banks in the US and Europe. She is now an independent consultant focusing on international payments and banking regulation and has published and spoken widely on the subject.

1 Established in January 2011, the European Banking Authority (
) is an independent
authority which works to ensure effective and consistent prudential regulation and supervision across the European banking sector. Its overall objectives are to maintain financial stability in the
and to safeguard the integrity, efficiency and orderly functioning of the banking sector.

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In this article

At present, virtual currencies (VCs) represent a miniscule amount of transactions globally. In its opinion on VCs published in July 2014, the European Banking Authority (
) points out that “using a generous interpretation, the number of global virtual currency transactions has never exceeded 100,000 per day across the globe, compared to approximately 295 million conventional payment and terminal transactions per day in Europe alone (i.e. credit transfers, direct debits, e-money transfers, cheques, etc.)”. This said, public authorities around the globe are assessing how to deal with the phenomenon. The
, for example, commented: “A regulatory approach (…) would need to comprise, amongst other elements, governance requirements for several market participants, the segregation of client accounts, capital requirements and, crucially, the creation of ‘scheme governing authorities’ that are accountable for the integrity of a VC scheme and its key components, including its protocol and transaction ledger.” In other regions, the authorities do not (yet) see a need to regulate or focus on a different set of questions such as, for example: are VCs legal currency? Are they an ‘asset’, a ‘property’, a ‘financial unit’? If they are an asset, is it taxable? If so, does capital gains tax apply? In this article, Edith Rigler takes a closer look at the latest developments in the VC landscape and the emerging regulatory response.

The views expressed in this article are solely those of the author and should not be attributed to the European Payments Council.

The technology behind Bitcoin: Bitcoins exist as computer code based on cryptography and are stored on electronic wallets. Bitcoin does not require a central clearing house or financial institution clearing transactions. Users must have an internet connection and Bitcoin software to make payments to another public account/address. The user can send payments within a decentralised, peer-to-peer network, can purchase and sell Bitcoins through online exchanges and trade Bitcoins for traditional currencies.

Demand and supply: on the supply side, the infrastructure needed to support VCs is building rapidly. However, the demand for Bitcoin remains limited. Between 55 and 73 percent of Bitcoins are not in circulation, but are simply ‘hoarded’, i.e. they are held in accounts rather than being traded or spent. One suspects that this has to do with Bitcoin’s price volatility.

VCs as an alternative payment method: while VCs are not legal tender in any country right now, many perceive their value primarily as an alternative payment method: Bitcoin transactions are faster and cheaper than traditional payment transactions routed via banks. Bitcoin is also touted as helping financial inclusion of the unbanked: populations that do not have bank accounts but can access the internet could theoretically make or receive Bitcoin payments. However, these benefits are more relevant in emerging markets and less relevant in the European Union (
), where existing and pending
legislation is already explicitly aiming at increasing transaction speed and reducing cost. The advent of
has played an important part in this regard.

The emerging regulatory response: national regulators everywhere have started to review VCs. Some have banned VCs, others restrict certain activities, and a third group are still monitoring and reviewing their position. Several central banks have issued warnings about the risks of investing in VCs. The regulatory response will ultimately depend on whether VCs will become a viable alternative payment method as well as their impact on financial stability and monetary policy.

The content of this article was first published with a series for the Equens Blog. The European Payments Council (
) wishes to thank the author and Equens for the permission to publish this article in the
Newsletter.

Edith Rigler

Independent consultant focusing on international payments and banking regulation&nbsp;